On Aug. 13 the Public Company Accounting Oversight Board (PCAOB) exposed proposed changes to the standard auditor’s report that have the potential to impact the relationship between auditors and their clients.

The proposal most likely to generate controversy is that which requires identification of what the auditors determined to be ‘critical audit matters.’ This will mean that audit decisions that are currently not shared with the public, and most often are not even disclosed to the clients, will be set forth for financial statement users.

The second of the proposed requirements pertains to auditor independence, auditor tenure and an auditor’s responsibility for information that is outside the financial statements but that is included in the financial statement filings. Auditors have long been required to at least ‘read and consider’ other information included in documents containing audited financial statements. This is in an effort to be assured that information, such as the management discussion and analysis section of Form 10-K, does not contradict or conflict with what the financial statements convey about the reporting entity’s financial position or results of operations. This rule was imposed in reaction to observed situations where disparate implications could be drawn from the financial statements and footnotes, on the one hand, and narratives such as the ‘chairman’s letter,’ which sometimes would present a rosier scenario than would seemingly be warranted by the ‘hard data’ in the financial statements, on the other hand.

The last of the three proposals amplifies slightly the already-extant options for the auditors to include certain explanatory paragraphs, addressing matters that, in the auditors’ judgment, deserve to be emphasized. It also draws attention to the so-called ‘going concern’ language when there is substantial doubt that the reporting entity will be able to survive for a year beyond the balance sheet date. These changes, too, are not deemed likely to garner opposition from the profession, or to expand auditors’ exposure to litigation.

What specifically would citing critical audit matters entail?

According to the PCAOB, critical audit matters are those matters addressed during the audit that:

Involved the most difficult, subjective or complex auditor judgments.

Posed the most difficulty to the auditors in obtaining sufficient appropriate evidence.

Posed the most difficulty to the auditors in forming the opinion on the financial statements.

Most firms’ internal audit guidance materials, such as manuals, programs and checklists, require that auditors plan their audits on the basis of financial statement assertions. Inherent and control risks must be considered for each of these assertions so that appropriate planned audit procedures can be selected or developed for each material assertion. Unless litigation later arises, these audit judgments are not generally shared with others, even with client personnel. Thus it is a radical departure to propose that critical audit matters be explicitly set forth in the auditors’ report or be made public in any other manner.

Will the PCAOB proposal improve the efficacy of audits?

As the SEC, the PCAOB and assorted academic researchers have documented, the predominant reasons audit failures occur among public companies are: